Joint Investigation Report into Strategic Defence Procurement Packages

Meeting report

FINANCE PORTFOLIO COMMITTEE
3 December 2001
JOINT INVESTIGATION REPORT INTO STRATEGIC DEFENCE PROCUREMENT PACKAGES

Chairperson: Ms B Hogan (ANC)

Relevant Documents
Joint Investigation Report into the Strategic Defence Procurement Packages
Statement by National Treasury on the Costs of the Strategic Defence Procurement Programme (included in the minutes)

SUMMARY
National Treasury presented a statement on the costs of the strategic defence procurement programme. It was pointed out that the 2001 budget estimates the cash flow expenditure on procurement at R43.8 billion over a 12 year period. In the 2002 budget an updated estimate of expenditure will be provided that takes into account the depreciation of the Rand over the past year.
 
MINUTES
The Chair introduced Mr Benjamin, Mr Mahlangu, Mr Van Tonder (Auditor General’s Office) and Mr Fourie (Public Protector’s Office) and said that they would be observing the meeting.

Ms Ramos (Director General, National Treasury) indicated that she did not know the exact purpose of the meeting. The document provided sets out the manner in which costs are arrived at and gives the breakdown. Mr Donaldson (DDG, National Treasury) took the Committee through the document. The presentation outlined three matters. The contract price as stipulated in the supply contracts, the R30 billion that projects into R43.8 billion over the full 12 year period and the financing of the package. Mr Donaldson took the committee through the statement that follows:

NATIONAL TREASURY
Statement on the Costs of the Strategic Defence Procurement Programme
3 December 2001

Introduction
On 25 November 1999, Cabinet approved that the Department of Defence should proceed with the procurement of strategic defence equipment to be partially financed through tied foreign loan facilities. This decision followed an affordability review and negotiations with identified suppliers during which the equipment specifications, industrial participation obligations and financing arrangements were examined in detail.

This procurement programme extends over a twelve-year period. The purchase agreements specify the costs of the equipment to be purchased in 1999 prices (“contract price") and provide for standard escalation in line with inflation in the relevant currency (“price adjustments").  The total costs of the strategic defence procurement programme at contract price are summarised below, followed by a projection of the expected cash flow expenditure after taking into account price adjustments and exchange rate depreciation. The terms of the associated financing agreements are also outlined below.

Total cost at contract price
The defence procurement contract commitments entered into (at "contract price") amounted to R30 050 million, or US$4 808 million in 1999 prices at the then exchange rate of R6,25 to the US$.

The total cost includes the foreign currency-denominated purchase prices of imported supplies, Rand-denominated prices of local supplies, the premium and fees associated with export credit facilities and interest on short-term supplier credits and programme management and statutory costs (mainly VAT payments). Details are set out below.

Strategic defence procurement programme at contract price

Of the total cost at contract price, R22,1 billion (70,2 per cent) comprised foreign supplies and R3,2 billion (10,5 per cent) local supplies. Statutory and programme costs, including South African tax payments, amounted to R4,7 billion. ECA premium payments and financing costs amounted to R1,1 billion. (Excluding costs relating to the financing arrangements, the total contract price amounted to R29,0 billion.)

The final cost of R30,05 billion at contract price was somewhat lower than the total cost approved by Cabinet on 25 November 1999. In approving the supply contracts, Cabinet noted that the estimated total costs in 1999 rands (as of 24 November 1999) amounted to R30 285 million, broken down as follows:
                                                                                                R Million
Corvette patrol vessels (4)                                                         6 873
Submarines (3)                                                                          5 531
Light utility helicopters (30)                                                        1 965
Aircraft (tranche 1)
      Hawk 100 trainer (12) and Gripen dual fighter (9)                    7 830
                                                                                                _______
                                                                                                22 199
Aircraft (tranches 2 & 3)
Hawk 100 trainer (12) and Gripen single fighter (19)                      8086
                                                                                                _______
                                                                                                30 285

The contract commitments diverge from the estimates noted by Cabinet in November 1999 mainly because of a reduction in the negotiated contract prices of the trainer and fighter aircraft.

Projected cash flow expenditure estimates
These procurements extend over a 12-year period.  As 5 typical of purchase agreements over an extended period of time, the contracts provide for inflation-related escalation of costs ("price adjustments").

Estimates of the projected cash flows over the full 12-year period were published in the February 2001 Budget, including the second and third Hawk and Gripen tranches. The projections diverge from the contract price costs above for two reasons:

·           Increases in the Rand value of foreign currency commitments as a result of the projected depreciation of the Rand relative to contract currencies, and

·           Inflation-related escalation of both Rand and foreign currency-denominated costs as provided for in the contracts.

In practice, there may also be divergences from these estimates as a result of variations in the timing of supplies and the completion of project phases.

"Expenditure" here refers to actual payments to suppliers or service providers, including premiums and fees associated with the credit facilities, but excluding interest on the separate financing agreements which is treated as part of state debt cost.

The 2001 Budget estimates of the total cash flow expenditure on the strategic defence procurements are set out below.   Expenditure on the procurement programme rises to a peak of R5,8 billion in 2003/04, or about 2,0 per cent of the overall budget, and amounts to a projected R43,8 billion over the full procurement period. (Excluding the export credit premiums which are part of the financing costs, total expenditure would be R43,0 billion.)

The 2001 Budget estimates took into account exchange rate and Inflation projections done in September 2000, with starting 2001 rates of R7,1 1 to the USD, R7,68 to the Euro and R1 1,09 to the GBP. The projections assume that the Rand will depreciate in line with the difference between average inflation in South Africa and the other contract currencies.

The 2002 Budget estimates will take into account the depreciation of the Rand in real terms against the contract currencies since these estimates were prepared.

Projected cash flow expenditure (2001 Budget estimates)

Loan agreements
Following finalisation of the respective supply contracts, the Government entered into loan agreements for the financing of the foreign currency components of these purchases on 25 January 2000.

These loans are underwritten by the export credit agencies of the countries supplying the equipment, allowing the South African Government to take advantage of the favourable terms and conditions characteristic of such facilities. In several cases, interest and currency options have been included in the loan agreements, providing a degree of flexibility to assist in managing these foreign debt liabilities. The loan agreements are summarised below.

Agreement with AKA Ausfuhrkrediet-Gesellschaft mbH, Commerzbank Aktiengesellschaft and Kredietanstalt fur Wiedereraufbau - for a tied buyer's credit for the purchase of four patrol corvette platforms:
            Contract price                                                   EUR 469,0 m
            Estimated maximum price adjustments               101,6 m
            Insurance costs                                                 3,7m
            HERMES fees and premiums                             37,7 m
            Maximum loan facility                                      611,9 m

This agreement comprises a Commercial Interest Reference Rate (CIRR) loan amount which has a Euro and a US $ component, and which finances 17,75 per cent of each drawdown at a fixed interest rate of 5,97% (Euro) and 7,32% (US$). Other loans can be set in either Euro, US$ or GB£ at a floating rate of Euribor or Libor plus a margin of 0,45%.  The loan agreement provides for conversion to fixed rate loans at equivalent market conversion rates, at the request of the borrower.

A commitment fee of 0,2% per annum is payable on undrawn amounts other than the CIRR facilities, and of 0,375% on the undrawn CIRR amounts.

Repayments are made in equal semi-annual installments over a 10 year period, beginning six months after delivery of each platform, or at the latest between January 2004 and May 2005.  Provision is made for prepayment options.

The loans are guaranteed by the Federal Republic of Germany, represented by the HERMES export credit agency of Germany.

Agreement with Societe Generale and Paribas for a French buyer's credit for the delivery of combat system suites and associated logistic support for four patrol corvettes, underwritten by the French export credit agency COFACE;

            Contract price                                                   EUR 142,9m
            Estimated maximum price adjustments               34,7m
            Insurance to COFACE                                        10,5m
            Maximum loan facility                                      188,1 m

This agreement provides for loans to be denominated either in Euro or US$, and for interest either fixed (4,89% Euro; 6,84% US$) or floating (0,45% above Euribor/Libor). Repayments occur over a 10 year period, beginning between 52 and 61 months after the effective date of the agreement. Provision is made for prepayment options.

The agreement is underwritten by the French COFACE agency, with credit insurance premiums ranging from 5,79% for the first tranche to 6,03% for the final loan tranche.

Agreement with AKA Ausfuhrkrediet-Gesellschaft mbH,  Commerzbank Aktiengesellschaft and kredietanstalt fur Wiedereraufbau - for a tied buyer's credit for the purchase of three HDW Class 209 Type 1400 MOD submarines together with logistical support and equipment:
           
            Contract price                                       EUR 628,8 m
            Estimated maximum price adjustments   130,3 m
            Interest for delayed payment                  31,5 m
            Insurance costs                                     4,9m
            HERMES fees and premium                  50,8 m
            Maximum loan facility                          846,3 m

The buyer's credit for the purchase of submarines is underwritten by the German HERMES agency and provides for loans to be denominated in Euro, US$ or GB£. The agreement provides for a fixed interest CIRR facility for EUR 108,7 m (denominated in Euro and US$) and for floating rate loans for the remainder of the loan amount at a margin of 0,45% above Euribor or Libor.  These can be converted to fixed rate facilities at the borrower's request.

            Repayments occur in 20 equal installments over a 10 year period, beginning six months after delivery or at the latest between January 2006 and January 2008. Provision is made for prepayment options.


Agreement with Mediocredito Central SpA and several banks - for a buyer's credit facility for purchase of 30 Agusta light utility helicopters plus logistical support, underwritten by the Italian SACE export credit agency.
           
            Contract price                           US$ 187,8m
            SA CE premium and fees          12,Om
            Maximum loan facility              199,8m

Repayment of this US$-denominated loan occurs in 20 semi-annual installments beginning on a starting point given by the weighted mean date of delivery, or 60 months after the date of the agreement. Provision is made for pre-payment.

Interest is either fixed or floating subject to borrower's election. The floating rate is 0,50% above Libor.

Agreement with Barclays Bank plc - for an export credit facility to be underwritten by the UK Government (Export Credit Guarantee Department) to finance the purchase of 24 Hawk trainer aircraft and 28 Grip en fighter aircraft (with a cancellation option for the second tranche of 12 Hawk trainers, equipment and supplies for the first tranche of 9 dual Gripen fighter aircraft and the second tranche of 19 single Gripen fighters):
           
Total loan facilities:       Hawk    Gripen
                                    GB£390,2m       GB£305,2m
                                    US$ 461,6m
                                    SKr 6428m

This agreement provides two tranches of GB£ denominated loans for the purchase of the Hawk trainer aircraft, and three tranches relating to the Gripen which include GB£, US$ and SKr sub-tranches. The borrower can exercise several choices within each tranche, effectively selecting a mix of currency commitments and a fixed or floating rate commitments. The agreement also allows the borrower to elect a gold-denominated loan, up to a maximum of GB£ 330m.

The floating multi-currency options carry interest at 0,4% above relevant libor or Euribor rates, securitisation tranches a margin of 0,175% and gold advances carry a margin of 0,5% above the gold interest implicit in the forward market. Floating rate loans can be converted to fixed interest loans. Provision is made for fixed interest advances at interest rates of 6,77% (GB£), 7,14% (US$) 6,01% (SKr) and 5,63% (Euro). The agreement provides for interest capitalisation advances, thereby deferring repayment until 2006 for the first tranche and 2011 for the final tranche of the programme.

Conclusion

The Government has contracted with foreign suppliers for the purchase of four corvettes and their combat suites, three submarines, 30 light utility helicopters, 24 Hawk trainer aircraft and 28 Gripen fighter aircraft, at a total contract price of R30,05 billion (in 1999 prices) or US$48 billion.

The 2001 Budget estimate of the total cash flow expenditure on this procurement programme is R43,8 billion over 12 years. An updated estimate of expenditure will be published in the 2002 Budget, taking into account revised exchange rate and inflation projections.

Financing agreements for the foreign cost components of these purchases have been concluded with a number of foreign banks, taking advantage of export credit facilities backed by the governments of the United Kingdom, France, Italy and Germany. These agreements provide for the repayment of loans over a maximum of a ten-year period.

Budget Office
National Treasury

Discussion
Ms Taljaard (DP) asked to what extent the Warburg-Dillion-Reid model is used. Secondly she wanted to know if there would be further financing for the purchase of the maritime helicopters because it was part of the corvette deal at the beginning.

Ms Ramos replied that she had thought that questions would be directed at Chapter 9. Treasury cannot comment on the compatibility of the marine helicopters with the corvettes. This is a question for the military.

Ms Hogan said that she also wondered about the maritime helicopters and if it was part of the package.

Mr Donaldson said that it was not part of the package. The Warburg-Dillion-Reid (WDR) model has many versions of the model and is used frequently. It is an instrument to do the arithmetic more efficiently.

Dr Koornhof (UDM) questioned whether Cabinet was provided with all the finance costs. In some paragraphs it is indicated that the full finance cost was not included.

Mr Donaldson said that the financing considerations was part of the evaluation and that the projected expenditure of R43.8 billion does not include the finance costs.

Dr Koornhof said that according to the report the amount of R30, 285 billion was presented to the Chief of Acquisition. He asked what figures were presented to Cabinet before the contracts were signed and if the figures included the projected costs.

Ms Ramos replied that the contract prices were approved and that financing was another matter dealt with under the servicing of government debt.

Ms Hogan referred to 14.2.4 that recommends that all costs should be clear. She said that Cabinet should have the cash flow projections for servicing the debt but that she has no doubt that it was included in the affordability report. The last sentence of this paragraph refers to certain functionalities being removed. The Chair noted that because there was this removal, the SA Air Force would carry some of the costs and she wanted clarity on this.

Ms Ramos said that there is a confusion that the essential functionalities are not included. She said that the overall cost comes from the Defence budget and the whole package is fully budgeted for.

Ms Hogan asked if the government could still cancel the second and third tranches at no cost to the state.

Mr Donaldson replied that in respect of the aircraft there is a cancellation option for the 12 Hawk aircraft in the second tranche and for the 19 Gripen aircraft in the third tranche. He added that the unit costs in the first tranche are higher than in the second and third.

Ms Ramos again clarified that the whole package is included in the defence budget.

Dr Koornhof asked if the training of pilots, fuel etc is included in the projected cash flow expenditure.

Mr Donaldson replied that what exactly is included has to be clarified with the DoD.

Ms Taljaard made the point that the SANDF would need more funds especially if the restructuring programme does not take place.

Ms Ramos replied that if more money is needed, it would be a Cabinet decision on how to reprioritize the defence budget.

Ms Taljaard asked if Treasury was concerned that a preferred bidder had been announced before the affordability report was given to  Cabinet. She asked if this concern was communicated. Further, was Treasury concerned about the depreciation of the Rand.

Ms Ramos said that the best projections were used at the time. The WDR model used exchange rate projections that seemed feasible at the time. Today it is possible to say that the projections are out of line but Cabinet would have to apply its mind and say if it is affordable.

Mr Donaldson added that nobody could project then what the exchange rate was going to be now. He said that the model was just a tool and that the affordability depends on the imports as well as the exports. The increased costs are offset by the benefit to the economy provided by the exports.

Mr Louw commented that there appears to be a gap in the overall financing in that it is not part of the overall package. There are huge increases in financing costs and because of this it is the duty of Treasury to put all the costs before Cabinet to ensure that Cabinet understands what is involved.

Ms Ramos said that when Cabinet approves the budget, the costs of servicing debt is included in he budget. Chapter 6 of the Budget Review lists all South Africa’s debt commitments.

Mr Donaldson added that Armscor does not borrow from outside the budget framework. It was decided at the very beginning that the financing of the deal would be part of the cost of servicing the debt.

Ms Hogan said that the JIT reports that the financing costs are not included but this does not mean that it was not given to Cabinet.

Mr Louw said that any business has to factor in the cost of financing and suggested that the minutes of the Cabinet meetings should be looked at to see exactly what was presented.

Mr Donaldson replied that government is not a business and that decision on how to finance the debt is a decision Treasury takes.

Dr Koornhof asked how the depreciation of the Rand is likely to affect the budget deficit in 2002 and 2003.

Ms Ramos replied that the budget deficit in the MTBPS is 2.6% and it does include the Defence Packages.

Mr Donaldson added that the full package is included in the DoD budget and that the allocation to DoD is still under 2% of GDP.

There were no further questions. The Chair thanked Ms Ramos and Mr Donaldson and adjourned the meeting.